- Associated Press - Tuesday, August 10, 2010

More worried about the strength of the economic recovery, the Federal Reserve took a small step Tuesday to give it a boost.

Wrapping up a one-day meeting, the Fed said it will use the proceeds from its investments in mortgage bonds to buy government debt. That should help lower interest rates on mortgages and corporate debt, but it likely won’t have a dramatic impact on stimulating growth, economists say.

Delivering a more downbeat assessment of the recovery, the Fed now thinks economic growth will be “more modest” than it had anticipated at its late June meeting. Citing “subdued” inflation, the Fed said it would keep its target for a key interest rate at zero to 0.25 percent for an “extended period.”

The focus again on energizing the recovery is a shift from earlier this year, when the Fed was starting to lay out its exit strategy for eventually boosting interest rates.

Economists said the move to buy government debt on a small scale — about $10 billion a month — along with the other options at the Fed’s disposal, will have only a marginal impact on boosting economic growth.

With interest rates at record lows, Congress has more power than the Fed to stimulate the recovery, economists say. But they differ on whether the best action is through short-term government spending or tax cuts, or some combination of the two.

“The Fed’s remaining tools won’t be very effective unless we see a severe deterioration in financial market conditions,” said David Jones, head of DMJ Advisors, a Denver-based consulting firm and the author of several books on the Fed.

Still, investors reacted positively to the statement. Stocks that were down sharply before the announcement made up some lost ground. The Dow Jones industrial average, down about 102 points just before the Fed decision, was down about 27 points a short time later.

“They seem to have quite a handle on what’s going on, which is what you want them to do,” said Robert Pavlik, chief market strategist at Banyan Partners LLC in New York.

Treasury prices rose slightly as investors were pleased by the Fed’s plan to buy government debt, which would reduce the amount of Treasury securities in the market. The yield on the Treasury’s 10-year note, which moves in the opposite direction from its price, fell to 2.77 percent from 2.82 percent just before the announcement.

Rates fell, in part, because the Fed said it would use the proceeds it is earning on mortgage bonds to buy two-year and 10-year Treasury notes, and that it would buy an equal amount of government debt as existing bonds mature. The net effect is to keep its $2.3 trillion balance sheet steady, while shifting its holdings into more government debt.

Economists estimate that roughly $10 billion a month would be available to buy the government debt. The Fed said it expects to start buying the government debt Aug. 17. Details on the amounts of each operation will be published Wednesday.

In 2009 and early 2010, the Fed bought $1.25 trillion in mortgage securities, $175 billion in mortgage debt from Fannie Mae and Freddie Mac, and $300 billion in government debt. In March, the Fed ceased buying new mortgage securities and Fannie and Freddie debt.